Overcoming Financial and Legal Challenges for Social Enterprises

Lately there’s been a lot of talk about market-based solutions to social and environmental problems, including education, global warming and health care. Increasingly, entrepreneurs and investors have been looking for a way to address these issues and many others through a unique type of business called a social enterprise. As social enterprise increases across the globe, new financial and legal structures are being explored to help facilitate this exciting work.

What is social enterprise?

A social enterprise is an organization or venture that, according to the Social Enterprise Alliance, a) addresses social needs directly through their products and services or through the number of disadvantaged people they employ and b) uses earned revenue strategies to pursue a double or triple bottom line. Social enterprises address a wide variety of issues using a wide variety of business models, and include both nonprofits that use business models to pursue their mission, and for-profits whose primary purposes are social (as opposed to a socially responsible business whose primary purpose is still profit-driven).

What are the financial and legal challenges?

Due to the unique hybrid nature of social enterprises, they often face financial and legal challenges. For instance, they can have a difficult time securing foundation funding. Foundations are allowed to make program related investments, or PRIs, that include equity investments in for-profit ventures that further a charitable objective. However, most foundations don’t do this because of the strict tax laws surrounding PRIs. On the other hand, it can be difficult for social enterprises to secure private investment capital due to its primary focus on social benefit over profits.

Another issue arises in liquidity scenarios. Current law requires that a company take the highest offer regardless of the impact of that decision on non-financial interests. One famous example of a socially-conscious company who decided to take the highest bid for fear of stakeholder litigation was Ben & Jerry’s.

What solutions are being proposed?

Solutions to these issues have taken several forms, including new corporate structures and innovative financing mechanisms.

Among the latest corporate structures are L3Cs, or low-profit limited liability companies, and Benefit Corporations. L3C status was created in large part to allow foundations to more easily fund social enterprises, and the requirements for an L3C were designed to mirror the IRS requirements for PRIs. As opposed to an LLC, an L3C is required to pursue a charitable or educational purpose as its main objective, though it can still earn a profit. Vermont was the first state to approve L3C legislation. Eight states have followed and several more are currently considering it.

Benefit Corporations were created by the Philadelphia-based non-profit B Lab, and legislation has passed in four states to legalize this new type of corporation. A Benefit Corporation 1) has a corporate purpose to create a material positive impact on society and the environment; 2) has an expanded fiduciary duty that requires consideration of non-financial interests when making decision; and 3) reports on its overall social and environmental performance as assessed against a third party standard. One of the main benefits to becoming a Benefit Corporation is that they can’t be held liable by courts for failing to place profits over other considerations.

Regardless of a social enterprise’s corporate structure however, they can look to impact investing to fill the gap between charitable donations and traditional investment. Impact investing is not simply socially responsible investing, where investors choose not to invest in “bad” companies. Instead, impact investors are looking to solve social or environmental challenges, while still making a profit. Furthermore, with minimum investments often around $1 million, this is not the same as microlending. And like traditional investors, there is a defined plan to sell the investment after a specific amount of time. Impact investing has enormous potential to focus large sums of money on solving today’s most pressing social and environmental issues.

What’s next?

Despite the progress that’s been made in overcoming financial and legal challenges to social enterprise, there is still work to be done. One huge question that still looms over the heads of many social entrepreneurs and their investors is – what does success look like? Defining metrics and striking a balance between social good and financial returns continues to be a challenge. Also, when it comes to impact investing, the lack of basic market infrastructure, like standards for measuring performance, and mechanisms, like rating agencies and clearinghouses, is hampering the ability of investors to make a difference. And finally, the IRS has yet to automatically qualify L3C investments as PRIs. Fortunately though, there are a lot of people and organizations (such as Global Impact Investing Network and Social Capital Markets) that are excited about taking on these challenges. Social enterprise is growing rapidly and as it continues to achieve recognition by our financial and legal institutions, it will become an even more powerful force in our efforts to effect social and environmental change.